Thanks to my house move last week it’s been a little while since my last update, during which equities and bonds have been on another round trip encompassing the latest US inflation data and the Federal Reserve meeting. Both events caused some reaction in financial markets, but as time has passed we have ended up pretty much where we started, with global equities close to all-time highs and government bonds holding steady at levels slightly lower than where they reached earlier in the Spring.
We’ll start with the US inflation data, which for the second month in a row has surprised to the upside, with CPI in May at 5% year on year, compared to 4.7% expected. April and May have been the strongest two months of inflation in the US for over a decade, with the 5% May CPI level the highest since 2008; indeed, we have seen higher inflation in only two months going all the way back to 1982! Core CPI (which excludes food and energy) was up 3.5% year on year, the highest rate of growth since 1992. So why, despite the odd jitter, are financial markets not freaking out given these inflation levels? Probably two reasons – the first being that year-on-year comparisons with last April and May, when the US economy was basically closed, means that the numbers are likely to be heavily distorted. The second is that the Federal Reserve has done a good job so far in convincing investors that they are for now not concerned with what they see as temporarily elevated inflation in the belief that inflation will settle towards their 2% target once the economic reopening bottlenecks and distortions ease over the coming months.
The Federal Reserve meeting that took place last week was the first since mid April; since then we have seen the two eye-watering inflation prints published. The initial reaction to the Fed meeting was that the tone was slightly more hawkish in that the Fed at least acknowledged there was a risk of inflation being more persistent. The ‘dot plot’ that shows the expectations of Fed members of where interest rates will be in the future now suggests two rate hikes, totalling 0.25% by the end of 2023. In an environment where the US economy is set to grow by 6% this year, to be told that rates will be unchanged for another 2+ years should be positive for risk appetite, but there seems to be plenty of uncertainty for now, even though the likely outcome remains that interest rates will stay extremely low for an extended period. Fed Chair Jay Powell said that “talking about talking about tapering” has now occurred and on inflation said “shifts in demand can be large and rapid, and bottlenecks, hiring difficulties and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than we expect”. The debate over inflation, and how central banks react to it, will continue to dominate market sentiment for the coming months until we either see inflation ease back, or there is more evidence that inflation is indeed more persistent.
The European Central Bank (ECB) and Bank of England have also held meetings over recent weeks. The ECB saw no change to interest rate policy, with their quantitative easing package purchases to continue “at a significantly higher pace than during the first months of the year”. The ECB also upgraded their growth forecast for the eurozone to 4.6% (from 4.0% in March) for 2021 and to 4.7% for 2022. The Bank of England made no change to policy, as expected, with interest rates held at 0.1% and the stock of quantitative easing unchanged at £875 billion. The Monetary Policy Committee “judges that inflation expectations remain well anchored” and they expect the period of above target inflation to be temporary. The minutes of the meeting showed that the Bank believes that “policy should ensure that the recovery was not undermined by a premature tightening in monetary conditions”.
Elsewhere in the economic data we’ve seen more evidence of the UK economic recovery, with growth of 2.3% in April, helped by strong retail spending. The economy is now 3.7% smaller than in February 2020 – the smallest gap since the start of the crisis. UK inflation hit 2.1% in May, driven higher by used car prices, clothing, restaurants and hotels. This was the first time for over two years that inflation has been above the Bank of England’s target, though much like in the US, the central bank still sees inflation as transient. In China, the retail sales and industrial production data missed expectations, with growth of 12.4% and 8.8% respectively over May 2020. While China is still expected to see growth close to 10% this year, there are building expectations that the authorities will loosen monetary policy somewhat in the second half of this year to ensure the economy builds some momentum. The flash PMI data for June was published on Wednesday of this week and continues to point to a solid economic recovery across western economies, albeit with notable price pressures in some sectors. The eurozone PMI composite of manufacturing and service data touched its highest level in 15 years. The UK and US PMI numbers eased slightly from the very strong numbers seen in May, but still pointed to a positive growth outlook.
In the world of politics, the G7 summit in Cornwall saw world leaders commit to ramping up contributions to the global ‘Covax’ distribution network in an attempt to vaccinate the vast majority of the world by the end of 2022. The subsequent meeting of NATO echoed some of the themes of the G7 summit, with the US pushing for other countries to stand up to a more assertive China. The NATO summit statement said “China’s stated ambitions and assertive behaviour present systemic challenges to the rules based international order and areas relevant to Alliance security. US President Biden told the G7 he wanted a “build back better partnership” to be an alternative to China’s Belt and Road initiative. President Biden went on to Geneva to meet with Russian President Putin, telling him that the US would hold Russia accountable for cyber attacks originating there. More positively, the US and Russia would see their respective ambassadors return to Moscow and Washington. The US moved a step closer to a deal on infrastructure spending yesterday as part of President Biden’s economic stimulus package with a bipartisan agreement between the President and Senators over a $1.2 trillion infrastructure plan covering the next 8 years including $579 billion of new spending. Biden signalled this remains part of a wider package that could amount to $2-3 trillion when the “human infrastructure” element was included. This package will not see cross-party support but should still pass thanks to the Democrats majority in Congress. Both packages should be positive for growth, with the investment in child and adult care provision, delivery of universal free pre-school places and tax credits for low income families all helping people return to the workforce.
As for the Covid-19 pandemic, the newsflow remains somewhat mixed – overall the case numbers globally continue to ease, though concerns over another wave in Latin America as winter takes hold are building. This week Brazil has seen record numbers of new daily cases. In the UK we are also seeing rising case numbers – we are back to the level of daily cases seen in early February – and while the rate of growth is easing somewhat, we are seeing significant transmission between the younger people and those not yet fully vaccinated. While this does not lead to as severe symptoms or hospitalisations, the climb in numbers in the UK is in stark contrast to the rest of western Europe or the US, where the Delta variant is not (yet) dominant. The rapid transmission and dominance of the Delta variant will continue to pose concerns for policymakers that wish to continue to ease restrictions domestically and on international travel. We have seen this in the UK, where the next stage of easing restrictions has been pushed back by 4 weeks with continued restrictions on foreign travel. Even as the UK adds countries to the ‘green list’ for international travel, other countries are tightening quarantine restrictions. The European Council, currently meeting in Brussels has seen Angela Merkel and Emmanuel Macron pushing for a unified EU policy banning travel from countries where the Delta variant is rampant. What is positive is that the vaccine rollout, at least across the western world, continues at a pace. In the UK, with vaccinations now open to all adults, over 60% of the adult population has now had two vaccine doses. In time, vaccinations will unlock some of the travel restrictions, but the testing regime may well remain in place. Financial markets will spend the next few months pondering inflation; the rest of the world will be focused on the race between the vaccine rollout and the next wave of the pandemic.
I think Gary’s email from last Friday more than covered off what we’re thinking right now – despite a lot of noise over the past fortnight financial markets remain somewhat range bound for now with equities overall looking richly valued (with some relative exceptions such as the UK) and very little on offer from bonds. We still see a lot of good news priced into market levels and remain comfortable being slightly cautious in our positioning for now.